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McKinsey Global Institute

How to compete and grow: A sector guide to policy

March 2010

The McKinsey Global Institute

The McKinsey Global Institute (MGI), established in 1990, is McKinsey & Company’s business and economics research arm. MGI’s mission is to help leaders in the commercial, public, and social sectors develop a deeper understanding of the evolution of the global economy and to provide a fact base that contributes to decision making on critical management and policy issues.

MGI combines three disciplines: economics, technology, and management. By integrating these perspectives, MGI is able to gain insights into the microeconomic underpinnings of the long-term macroeconomic and business trends that affect company strategy and policy making. For nearly two decades, MGI has utilized this distinctive “micro-to-macro” approach in research covering more than 20 countries and 30 industry sectors.

MGI’s current research agenda focuses on global markets (capital, labor, and commodities), the dynamics of consumption and demographics, productivity and competitiveness, the impact of technology, and other topics at the intersection of business and economics. Recent research has examined the economic impact of aging consumers and household debt reduction in developed countries, the emerging middle class in developing countries, health care costs, energy demand trends and energy productivity, and long-term shifts in world financial assets.

MGI’s work is conducted by a group of full-time senior fellows based in offices in Beijing, Brussels, Delhi, London, San Francisco, and Washington, DC. MGI project teams also include consultants from McKinsey’s offices around the world and are supported by McKinsey’s network of industry and management experts and worldwide partners. In addition, leading economists, including Nobel laureates and policy experts, act as advisers to our work.

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Copyright © McKinsey & Company 2010

James Manyika Lenny MendoncaJaana RemesStefan KlußmannRichard DobbsKuntala KarkunVitaly KlintsovChristina KükenshönerMikhail NikomarovCharles RoxburghJörg Schubert Tilman TackeAntti Törmänen

McKinsey Global Institute

March 2010

How to compete and grow: A sector guide to policy

4

Preface

How to compete and grow: A sector guide to policy builds not only on McKinsey & Company’s industry expertise but on nearly two decades of sector-level analysis by the McKinsey Global Institute (MGI) in more than 20 countries and 28 industrial sectors. The report is part of a broader ongoing MGI research effort on the topic of growth and renewal. In the latest research, we have studied competitiveness and growth in six industries (retail, software and IT services, tourism, semiconductors, automotive, and steel) across eight countries in each case, including both emerging and high-income economies. Many governments have signaled their intention to become more proactive in the market in pursuit of sustainable growth and enhanced competitiveness. Our aspiration is to provide a fact base for such efforts and to inform the private sector's dialog with policy makers around the world.

Jaana Remes, MGI senior fellow, led this project, with guidance from James Manyika, Lenny Mendonca, Vitaly Klintsov, and Jörg Schubert. The project team comprised Kuntala Karkun, Stefan Klußmann, Christina Kükenshöner, Mikhail Nikomarov, Tilman Tacke, and Antti Törmänen. The team also benefited from the contributions of Janet Bush, MGI senior editor, who provided editorial support; Rebeca Robboy, MGI external communications manager; Vilas Kotkar, team assistant; and Marisa Carder and Therese Khoury, visual graphics specialists.

We are grateful for the vital input and support of numerous McKinsey colleagues around the world. These include Ruslan Alikhanov, Andreas Baumgartner, Frank Bekaert, Philippe Bideau, Stefan Biesdorf, Urs Binggeli, Francois Bouvard, Harry Bowcott, Dirk Breitschwerdt, Stefan Burghardt, Justin Byars, V. Chandrasekar, Michael Chui, John Dowdy, Karel Eloot, Christoph Eltze, Luis Enriquez, Daniel Feldmann, Christophe François, Steffen Fuchs, Christian Gschwandtner, Toralf Hagenbruch, David Hajman, Stefan Heck, Russell Hensley, Michael Herter, Martin Hjerpe, Scott Jacobs, Noshir Kaka, Osamu Kaneda, Axel Kalthoff, Martin Kolling, Stefan Knupfer, Axel Krieger, Kevin Krogmann, Sigurd Mareels, Tim McGuire, Sarah Monroe, Nicolai Muller, Yuji Nakahara, James Naylor, Bettina Neuhaus, Becca O'Brien, Loralei Osborn, Andreas Pecher, Tom Pepin, Niels Phaf, Luiz Pires, Philipp Radtke, Stefan Rehbach, Sergio Sandoval, Vishal Sarin, Yasushi Sawada, Sven Smit, Robert Stemmler, John Strevel, Yeonkyung Sung, Mourad Taoufiki, Fraser Thompson, Davide Vassena, Ruben Verhoeven, Sanjay Verma, Uma Vohra, Bill Wiseman, Dilip Wagle, Jonathan Woetzel, Jiajun Wu, Simei Wu, and Andreas Zielke.

Distinguished experts outside McKinsey provided invaluable insights and advice. We would particularly like to thank Martin N. Baily, a senior adviser to McKinsey and a senior fellow at the Brookings Institution; Dani Rodrik, professor of International Political Economy at the John F. Kennedy School of Government, Harvard University.

5How to compete and grow: A sector guide to policyMcKinsey Global Institute

This report contributes to MGI’s mission to help global leaders understand the forces transforming the global economy, improve company performance, and work for better national and international policies. As with all MGI research, we would like to emphasize that this work is independent and has not been commissioned or sponsored in any way by any business, government, or other institution.

James Manyika Director, McKinsey Global Institute Director, McKinsey & Company, San Francisco

Richard Dobbs Director, McKinsey Global Institute Director, McKinsey & Company, Seoul

Susan Lund Director of Research, McKinsey Global Institute

Charles Roxburgh Director, McKinsey Global Institute Director, McKinsey & Company, London

March 2010

How to compete and grow: A sector guide to policyMcKinsey Global Institute

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Contents

Executive summary 9

1. Looking at sectors is the key 17 to understanding competitiveness and growth

2. Patterns in sector contributions to growth 23 challenge conventional wisdom

2.1 The competitiveness of sectors matters more 26 than the sector mix

2.2 To generate jobs, service-sector competitiveness is the key 28

2.3 Competitiveness in new innovative sectors 29 is not enough to boost economy-wide employment and growth

3. Governments need to tailor policy to each sector 31

Bibliography 50


9

As we emerge slowly from the first global recession since World War II, governments and businesses share an overarching aim—to steer their economies toward increasing competitiveness and growth. Many business leaders advocate a greater role for government in this effort. Intel Corporation’s former chairman Craig Barrett has urged governments to implement policies “to grow smart people and smart ideas.”1 Rolls-Royce chief executive Sir John Rose has argued for the credit crunch to be a catalyst for a sharper focus on industrial competitiveness.2

Many governments are already being more proactive in trying to boost growth and competitiveness. Given the fragility of the business and economic climate—and strained public coffers—the responsibility to get policy right, and thereby and create a solid foundation for long-term growth, is acute.

Fostering growth and competitiveness is a perennial challenge among policy priorities, but past experience shows that governments have, at best, a mixed record in this regard. There have been solid successes but also damaging failures—ineffective interventions that have proved costly to the public purse, and even regulation that has had negative, unintended consequences for the conduct of business.

An important reason why government intervention in markets has been hit or miss is that action has tended to be based on academic and policy research that has looked through an economy-wide lens to understand competitiveness—in other words, whether one country is “more competitive” than another.

The top-down analysis has all too often failed to capture the fact that the conditions that promote competitiveness differ significantly from sector to sector—and so therefore do the most effective potential regulations and policies. The McKinsey Global Institute (MGI) has analyzed the performance of more than 20 countries and nearly 30 industry sectors (see box 1 “Defining sector competitiveness and growth”). On the basis of our experience, we believe that effective policy making needs a new approach.

Only by analyzing what drives growth and competitiveness in different sectors of the economy—and then tailoring the policy response and executing policy in close collaboration with the private sector—can governments boost their odds of intervening effectively. This paper seeks to provide fact-based insights to help governments make the right decisions and trade-offs, drawing on MGI's bottom-up, sector-based approach.

1 Davos: Craig Barrett on the post-crisis world, January 29, 2009 http://blogs.intel.com/csr/2009/01/.

2 “Made in Britain,” World in 2009 edition, Economist, November 19, 2008.

Executive summary

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Box 1. Defining sector competitiveness and growth

Competitiveness is a fuzzy term used to mean many different things. For each sector, MGI defines competitiveness as a capacity to sustain growth through either increasing productivity or expanding employment.3 A competitive sector is one in which companies improve their performance by increasing productivity through managerial and technological innovations, and offer better quality or lower-priced goods and services, thereby expanding demand for their products. This approach enables us to shed light on the microeconomic dynamics behind growth in each sector, to identify variations in the relative competitive performance of different sectors, and to analyze the impact of different policy choices on growth and employment.

MGI’s definition applies equally to sectors that produce tradable products, like cars, and those that produce nontradable services, such as retail.

Capturing global market share. For tradable goods and services, competitiveness makes intuitive sense as the attractiveness of a location for new investments and the capacity of local operations to compete regionally or globally, generating growth in their sector overall. For example, Brazil has become the largest poultry exporter in the world by combining global best-practice processes with low factor costs; the poultry industry created jobs and growth in the host economy as a result.

Growing domestic market. For local services, we also interpret competitiveness as the capacity to generate growth. However, in these sectors, growth comes from the creation and expansion of a domestic market. Those service sectors that offer appealing services and products at attractive prices to local consumers and businesses will create jobs and boost productivity. For example, a higher-cost and more limited restaurant and hotel offering in Sweden explains why consumers spend less than half as much of their consumption on these services as in the United Kingdom.

PATTERNS IN SECTOR CONTRIBUTIONS TO GROWTH CHALLENGE CONVENTIONAL WISDOM

To reach a better understanding of the underlying drivers of competitiveness, and the policies that empirically have been successful in promoting it, we studied the competitiveness and growth of six industries (retail, software and IT services, tourism, steel, automotive, and semiconductors) across eight or more countries in each case, including both emerging and high-income economies. Drawing on national account data and McKinsey’s global industry expertise, we measured differences in sector growth performance across countries and assessed what factors have been critical for explaining the competitiveness in each industry (e.g., skills and scale in semiconductor products; access to low-cost raw materials and energy, and efficient operations in steel). We then studied how different government policies have influenced the competitiveness levers and growth performance of different countries.

3 By sector growth, we mean increases in sector value added—the contribution of a sector to overall GDP growth. The economy-wide growth impact across sectors is a function of both individual sector growth contributions and the changes in shares of above- and below-average productivity sectors.


This report shares some of the key findings from the research. We believe that the lessons that emerge from our case studies are applicable to other sectors, both existing and emerging, and countries across different income levels.

By analyzing competitiveness at the sector level, we reach conclusions that run counter to the way many policy makers think about the task in hand. Many governments worry about the “economic mix”—and assume that if they achieve the “right” mix, higher competitiveness and growth will follow; our analysis finds that solving for mix is not sufficient. To avoid wasting their effort and resources, policy makers cannot take a one-size-fits all view, proposing identical policy solutions for globally competed sectors—whose competitiveness is not easy for governments to influence directly—and largely domestic sectors where regulation is often decisive. While many policy makers see innovative technologies as the answer to the challenge of job creation, our analysis indicates that governments are likely to be disappointed in such hopes. It may not capture the popular imagination but the quest for new jobs is much more likely to bear fruit in large local business and household-services sectors. Policy makers also need to take account of the stage of development of their economy. Sector contributions to GDP growth vary at different stages of a country's economic evolution and policy makers need to learn different skills sets in their efforts to enhance growth and competitiveness.4

Some of the key insights arising from our research are:

The competitiveness of sectors matters more than the mix

Some governments worry about the “mix” of their economies but our research finds that countries that outperform their peers do not have a more favorable sector mix that propels them to higher growth. Instead, their individual sectors are more competitive. The sectors that fuel growth by performing exceptionally strongly vary by country. What above-average growth countries have in common is that their existing large employment sectors—such as retail and restaurants; food processing; and construction—pull their weight by posting strong growth.

To generate jobs, service-sector competitiveness is the key

Many governments are looking to manufacturing sectors as a new source for growth and jobs in the aftermath of the financial and real-estate sector bust. But our research finds that services will continue to be critical for job creation. Productivity improvements are a key factor in all sectors but most job growth has come from services. In high-income economies, service sectors accounted for all net job growth between 1995 and 2005. Even in middle-income countries, where industry contributes almost half of overall GDP growth, 85 percent of net new jobs came from service sectors. So policy makers should ensure that domestic service sectors also continue to pull their weight.

Policy impacts nontradable sector competitiveness directly—in

tradable sectors, getting policy right is more complicated

Policy makers should take into account the fact that their influence on largely nontradable “domestic” sectors is more direct than it is in those sectors that compete globally. In nontradable sectors, sector performance correlates closely with the local

4 In the early post-agricultural phase, the industrial sectors of middle-income countries tend to peak and then decline. In these economies, goods-producing sectors contribute almost half of economic growth, with services accounting for the rest. As incomes rise, the share of services continues to grow. Almost 90 percent of overall GDP growth in developed countries came from services between 1995 and 2005.

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policy environment that sets the “rules of the game” for competitive market dynamics. Whether in telecommunications or retail, MGI case studies show that the employment and productivity outcomes of countries reflect the incentives to companies set by regulation. Regulation that facilities business entry tends to increase competition and productivity, while flexible hiring laws, lower minimum wages, and part-time employment arrangements correlate with higher employment and more rapid adjustment to change. Policy changes can impact sector performance in two to three years.5

In traded sectors, where success requires local companies to be competitive in the regional or global marketplace, policy requires broader understanding of the global industry landscape. Some regulations can unexpectedly halt sector growth—as obscure national security review requirements did for Russian software exports. In addition, financial incentives to failed initiatives can cost governments billions—as many semiconductor ventures have done around the globe. For the best odds for sustained growth, efforts to enhance competitiveness should target those activities with a realistic potential for competitive advantage and be based on solid business logic.

Competitiveness in new innovative sectors is not enough to boost

economy-wide employment and growth

Many policy makers are pinning their hopes today on innovative new sectors such as cleantech as the answer to the challenges of competitiveness, growth, and jobs. Yet the innovative emerging sectors themselves are too small to make a difference to economy-wide growth. Take the case of semiconductors. With employment of 0.5 percent or less even among mature developed economies, the sector’s direct contribution to GDP is limited. But ongoing innovations in the sector have contributed to the IT adoption that has improved business processes and boosted productivity in many other sectors—and therefore made a difference for economy-wide growth. Yet these broad user benefits often don’t require local suppliers. In fact, policy efforts to protect local sector growth—such as Brazil’s unique television standards—can halt growth if they increase costs and reduce the adoption and use of new technologies. For instance, low-tech, green jobs in local services—such as improving building insulation and replacing obsolete heating and cooling equipment—have greater potential to generate jobs than the development of renewable technology solutions. For policy makers concerned with abating carbon emissions in the near term, pushing the adoption and diffusion of low-carbon solutions is likely to make a bigger difference than technology production alone.

GOVERNMENTS NEED TO TAILOR POLICY TO EACH SECTOR

Tailoring policy for the myriad of different sectors in an economy is a complex task. For this reason, MGI has produced a new framework that we hope will help bring some clarity to government approaches to growth and competitiveness and streamline the necessary analysis.

We have identified six sector groups that share characteristics and respond to similar approaches to enhancing competitiveness: (1) infrastructure services; (2) local services; (3) business services; (4) research and development (R&D)-intensive manufacturing; (5) manufacturing; and (6) resource-intensive industries (Exhibit E1).

In each of these groups, we document how competitiveness levers vary and how policy has influenced competitiveness in each. We believe that these six categories

5 William Lewis, “The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability,” Chicago University Press, new edition October 21, 2005.


provide a useful framework for understanding what determines competitiveness in different kinds of industries and what tangible actions governments and businesses can take to improve competitiveness.

Exhibit E1

1.6

1.2

0

100101

0.4

0.8

-0.8

-0.4 Infrastructure

Local services

Business services

Resource-intensive industries

Manufacturing

R&D-intensive manufacturing

MGI categorizes sectors into six groups according to degrees of differentiation and tradability

SOURCE: EU KLEMS growth and productivity accounts; OECD input-output tables; McKinsey Global Institute analysis

Size of circle = relative amount of sector value added in 2005

Differentiation index0 = average

Diff

eren

tiatio

n of

pro

duct

s

High

Low

Tradability of products

Imports plus exports divided by sector gross output%

Low High

EXHIBIT E1

Electricity

ConstructionHotels and restaurants

Land transport

Wholesale and retail trade

Post and telecommunication Finance and

insurance

Real-estate activities

Computer and related activities

R&D

Pulp, paper, printing, and publishing

Agriculture, forestry,

and fishingWood products

Rubber and plastics

Basic metals

Fabricated metals

Machinery and equipment

Motor vehicles

Pharma

Chemicals

Radio, TV, and communication

equipment

Medical instruments

Aircraft and spacecraft

Other

Other

The spectrum of public policy interventions ranges from a hands-off approach limited to creating the necessary market institutions to being a central operator in a sector. We analyzed the policies used in different sectors in four categories that demonstrate an increasing intensity of intervention:

1. Setting the ground rules and direction. Governments can limit sector policies to setting the regulatory environment including labor and capital-market and general business regulation, and setting broad national priorities and roadmaps.

2. Building enablers. Without interfering with the market mechanism, governments can support the private sector by expanding hard and soft infrastructure; educating and training a skilled workforce; and supporting R&D.

3. Tilting the playing field. Governments can choose to create favorable conditions for local production, typically through trade protection from global competition; through the provision of financial incentives for local operations; or by shaping local demand growth through public purchasing or regulation.

4. Playing the role of principal actor. At the interventionist end of the policy spectrum, governments may play a direct role by establishing state-owned or subsidized companies; funding existing businesses to ensure their survival; and imposing restructuring on certain industries.

We found clear patterns linking sector competitiveness levers and effective policy, which governments need to factor into their design of competitiveness policies (Exhibit E2).

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Exhibit E2Government policy tools need to be tailored to suit sector competitiveness drivers

SOURCE: McKinsey Global Institute/Public Sector Office Competitiveness Project

Government as principal actor

Tilting the playing fieldBuilding enablers

Setting ground rules/direction

EXHIBIT E2

Infrastructure

Degree of intervention

HighLow


Infrastructure

R&D-intensive manufacturingBusiness services

Local services Manufacturing

In domestic sectors like telecommunications or retail that have limited trade, local regulation can directly determine the rules of the game and therefore guide both competitiveness and performance—yet in radically different ways in the various local sectors.

1. In infrastructure services like telecommunications, large economies of scale require that the regulatory environment finds the right balance between the cost savings available from single large-scale operators (who can amortize network build-out costs at a lower cost per customer and save on other fixed operating costs) with the incentives created by competition to offer new, attractive, and affordable service packages to the consumer. Early on, the United States auctioned wireless spectrum licenses for relatively small geographic areas with the aim of promoting competition. As a result, the 50-plus fragmented operators that emerged had much smaller subscriber bases and higher per-user costs shortly after they won licenses than mobile operators in France or Germany—that had three and four operators, respectively. The goal of competitive infrastructure services is typically not only to boost sector growth but also to ensure the broad penetration of high-quality infrastructure services that can raise productivity and output growth elsewhere.

2. In a local service sector such as retail, business turnover tends to be high and growth comes from more productive companies gaining share or replacing less productive ones. Competitive intensity is a key driver, providing an incentive for ongoing innovation and the adoption of better practices and ensuring that productivity gains are passed on to consumers in the form of more attractive products and lower prices. These more appealing offerings in turn boost demand, creating a virtuous cycle of expanding domestic demand and sector growth.

Productivity and employment in retail sectors around the world vary widely—largely due to regulation, MGI research shows. Regulation that allows the expansion of more modern retail formats raises productivity. After opening the sector to foreign investors, Russian retail productivity has more than doubled in the past ten years from 15 percent of the US level to 31 percent on the back of


gaining share of modern retailers. In Sweden, the liberalization of opening hours and zoning regulation unleashed competition, and productivity increased at an average of 4.6 percent for ten years after 1995. In contrast, France introduced more restrictive rules on the size of retail outlets in the 1990s, halting the sector’s productivity growth. Flexible hiring laws, lower minimum wages, and part-time employment arrangements tend to boost retail employment and service levels, as we have seen in the United States and the United Kingdom.

In innovative, globally competing sectors such as software and semiconductors, global industry dynamics and competition between companies are the key factors driving overall performance. In such sectors, it is harder for governments to have as direct an influence. What matters more is creating a strong enabling environment for private-sector success. Yet actions to boost competitiveness and the odds of success vary widely depending on the underlying industry economics. For instance, despite sustained public support for the development of local semiconductor clusters in several countries in recent years, the strong winner-takes-all dynamic of this sector has been prohibitive to new entrants.

3. In business services like software and IT services, access to talent—at the right cost—is a necessary condition for competitiveness. India, the Republic of Ireland, and Israel, all countries with exceptionally rapid IT services export growth, had a pool of skilled engineers available at a globally competitive cost. Favorable demand conditions—through strong local industry links (e.g., wireless in Finland), or public defense or other contracts (as in the United States)—have also helped nurture growth in these sectors. However, while many regions provide tax incentives for inbound software multinationals, MGI research suggests that such incentives are less critical and often unnecessary. And direct public ventures have failed to sustain competitiveness in the global market.

4. In R&D-intensive manufacturing such as semiconductors, the right enabling environment is as important as it is in software, but the capital intensity and very large economies of scale change the competitive dynamic. All sustained semiconductor clusters have benefited from public support. Such support has included early defense contracts in the United States and the provision of public capital in South Korea and Taiwan, hosts respectively to the world’s leading companies in the memory and foundry segments. Yet because of the very large economies of scale in new fabs and technology in today’s mature industry, there have been no new semiconductor clusters in the past 15 years that have generated sustained growth—despite efforts in Singapore, China, Germany, and many other regions. Large public investment incentives have led to very low returns to capital in the industry overall.

In industrial sectors like automotive and steel, competitiveness depends on a broad set of factors that collectively determine the “value for money” delivered. The competitive advantage of a location varies depending on the subsegment or even step in the value chain. As a result, there is a much broader array of policy tools available. Even so, policy has a mixed track record. The odds of success depend on whether the efforts are targeting activities that can have an inherent competitive advantage in the location, and on the execution of policy.

5. In manufacturing sectors like automotive, sector performance relates to the capacity of locally based companies to continue to offer attractive products at a competitive cost. Yet government policy has fundamentally shaped the sector both through trade policies that have created the regionalized industry and through increasingly high industry subsidies that have encouraged investment and capacity

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expansion globally. Experience shows that while trade protection has helped create local industries in many countries, it leads to low productivity. But when India, for instance, removed trade and investment barriers, productivity more than tripled. A range of other policies—from export promotion to state-owned car companies—have had mixed success and have been expensive. Host governments’ subsidies of more than $100,000 per job are provided in developed and developing countries alike, contributing to today’s global overcapacity.

6. In resource-intensive industries like steel, government intervention has played a role in most countries, but the policy tools employed have evolved over time. In a sector’s early development phase, governments have supported growth through trade barriers and financial support including subsidized funding and public investments. While most protected industries lag behind global best-practice productivity as a result, South Korea’s Pohang Iron and Steel Company (POSCO) managed to develop from being a supported state-owned steel company into a leading global company today. In all cases, sustained competitiveness after the initial developmental phase has required increasing exposure to global competition. When the sector is mature, government's main role has been helping coordinate the downsizing of the industry. In the late 1970s and 1980s, the European Community (EC) responded to the sector’s crisis by trying to protect it—a strategy that failed. When another steel crisis hit in the 1990s, the European Union (EU) rejected protection and was successful in supporting restructuring, helping more than half a million displaced workers to retrain and find work in other industries.

* * *

MGI's work over the last two decades shows that, in country after country, getting regulation right has been the key to boosting productivity and competitiveness. Moreover, we think policy makers will boost their odds of success if they take a sector view and draw on experience to learn what kinds of approaches to improving competitiveness have been effective—and which have not—in different sectors and situations. This is the analytical route MGI has taken in this report. By design, this approach generates detailed, actionable recommendations for public policy. Understanding the microeconomic barriers to competitiveness and growth allows MGI to identify the policy changes needed to improve performance, as well as to highlight critical regulatory constraints affecting specific sectors. Neither of these sets of insights is available through more traditional aggregate economic analyses.


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Most classical academic and policy research has looked through an economy-wide lens to understand the issue of competitiveness. Yet such aggregate perspectives fail to capture the drivers of competitiveness that vary from sector to sector—as well as the different impact that regulation and policy in the broader sense can have in various settings. It is no surprise that top-down econometric assessments of what drives competitiveness have often proved inconclusive and that government intervention in markets has tended to be hit or miss.6

We offer a new approach. Over the course of nearly two decades, MGI has used sector-level research in more than 20 countries and 28 industrial sectors, employing microeconomic intelligence to build a picture of macroeconomic outcomes.7 We believe that this micro-to-macro approach is vital in answering the question of enhancing competitiveness. To be able to explain differences in sector growth rates across countries, we need to understand the key drivers of competitiveness in each sector; how countries differ in their initial conditions; and the impact of a particular policy environment (see box 2, “The role of government in market economies”).

Box 2. The role of government in market economies

Policies have a strong impact on the competitiveness of all types of sector—but in radically different ways. For government policy, it is useful to think of sectors in three categories, each of which presents different challenges.

Competitive markets account for about 50 to 60 percent of economic activity. In this category, private-sector companies provide goods and services in competition with each other. These sectors include manufacturing (e.g., automotive and food processing) and services (e.g., food retail, retail banking, and construction). Government has a dual role in setting the institutional structure that facilitates those transactions that underpin a market economy, and in crafting regulation so that

6 Economic growth is analyzed from a macroeconomic perspective in the Solow growth model (1956); in the New Growth models in the 1980s and 1990s by Paul Romer, Robert Barro, and Robert Lucas Jr. among others; in the Schumpeterian growth models highlighting the role of innovation and creative destruction by Gene Grossman and Elhanan Helpman among others; as well as in the recent institutional and geographic growth literature introduced by Daron Acemoglu and others. In the past decade, economists have started to look for sector patterns behind aggregate economic growth. Prominent analyses include the OECD’s program The Sources of Economic Growth in OECD Countries, 2003 (http://www.oecd.org/dac/ictcd/docs/otherdocs/OtherOECD_eco_growth.pdf). Also see the European Commission’s EU KLEMs sector-level data-collection effort: Mary O’Mahoney and Bart van Ark, eds., EU Productivity and Competitiveness: An Industry Perspective, European Commission, 2003 (http://www.ggdc.net/databases/60_industry/2006/papers/eu_productivity_and_competitiveness.pdf). This work has focused largely on understanding how different sectors have contributed to overall economic growth. Our work goes further in seeking to understand through case studies how sectors differ in the ways that various external and policy factors explain their competitiveness and growth.

7 See Martin Neil Baily and Robert M. Solow, “International productivity comparisons built from the firm level,” Journal of Economic Perspectives, Volume 15, Number 3, summer 2001, pp. 151–72. For those interested in reading MGI reports on productivity and competitiveness in different countries, regions, and sectors, visit http://www.mckinsey.com/mgi/rp/CSProductivity/.

1. Looking at sectors is the key to understanding competitiveness and growth

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there is minimal unintended distortion to market incentives.8 These roles include establishing clear property rights and rules governing contracts; ensuring legal and fiscal reporting requirements are not unnecessarily costly and are evenly enforced; and implementing pro-competitive regulation and antitrust laws. Beyond these core tasks, governments tend also to take a broader approach that includes correcting for market imperfections (e.g., externalities such as pollution and information asymmetries), ensuring consumer health and safety, and meeting other strategic and social objectives (e.g., maintaining heritage sites through zoning laws).

Noncompetitive sectors account for some 10 to 20 percent of economic activity. The nature of these sectors means that there is no effective competitive dynamic among private-sector companies due to natural monopoly economics related to high-scale economics (e.g., utilities or telecommunications) and/or exclusive access to critical natural resources such as oil, coal, and wireless spectrum. In these sectors, government sets the rules of competition and incentives for private-sector players or, in the case of many countries, for state-owned enterprises.

Nonmarket activities account for around 25 to 35 percent of activity. These sectors include both pure public-sector services, such as defense, as well as health care and education. These sectors tend not to lend themselves well to purely market-based transactions because of long time lags between service and resulting benefits and their lack of easily observable metrics for quality. These are sectors where government has a more direct role as a regulator or operator.9

MGI’s in-depth sector analysis demonstrates that there is no one-size-fits-all explanation for the growth performance of sectors and that the key factors driving different degrees of performance vary by type of sector. To streamline our analysis of a complex picture, we have defined a new framework for analyzing competitiveness of sectors that divides the full range of sectors into six groups that share certain characteristics and respond to particular policy approaches.

MGI’S NEW FRAMEWORK IS BASED ON SIX SECTOR GROUPS

To arrive at our six group classifications, we use two major factors (Exhibit 1):

1. How tradable is a sector and therefore how subject to international competition is it? Sectors with significant imports and exports compete with international suppliers, and their performance relative to their counterparts in other regions matters for growth and employment performance. In contrast, sectors that largely focus on domestic markets—local services such as retail, for instance—tend to reflect local demand and the national regulatory environment directly.

8 Scott C. Beardsley and Diana Farrell, “Regulation that is good for competition,” McKinsey Quarterly, 2005 Number 2 (www.mckinseyquarterly.com).

9 This research focuses on private-sector performance but not that of the public sector. In the latter, competitiveness as we define it is difficult to measure because of a lack of reliable output measures or clear causality between sector expansion and underlying productivity and cost performance. McKinsey has addressed sectors including public services, health care, and education in other publications, including Tony Danker et al., How can the American government meet its productivity challenge? McKinsey & Company, July 2006; and Thomas Dohrmann and Lenny T. Mendonca, “Boosting government productivity,” McKinsey Quarterly, November 2004 (www.mckinseyquarterly.com). For those interested in health care, please see reports published by MGI at http://www.mckinsey.com/mgi/rp/healthcare/. For an analysis of education, see Michael Barber and Mona Mourshed, How the world’s best-performing school systems come out on top, McKinsey & Company, September 2007 (http://www.mckinsey.com/clientservice/Social_Sector/our_practices/Education/Knowledge_Highlights/Best_performing_school.aspx.


2. What degree of differentiation—or standardization—does a sector display? For commodity products, cost is the critical competitiveness driver. In sectors with more variance in quality, design, and so on, noncost factors such as expertise, innovation, and brand are key factors. Policy design needs to take account of these differences. For instance, policies that help to create scale or reduce transportation costs may be critical for commodity sectors, while education and R&D policies may matter more in sectors where differentiation is a significant feature.

Exhibit 1

1.6

1.2

0

100101

0.4

0.8

-0.8

-0.4 Infrastructure

Local services

Business services


Manufacturing


MGI categorizes sectors into six groups according to degrees of differentiation and tradability

SOURCE: EU KLEMS growth and productivity accounts; OECD input-output tables; McKinsey Global Institute analysis

Size of circle = relative amount of sector value added in 2005

Differentiation index0 = average

Diff

eren

tiatio

n of

pro

duct

s

High

Low

Tradability of products

Imports plus exports divided by sector gross output%

Low High

EXHIBIT 1

Electricity

ConstructionHotels and restaurants

Land transport

Wholesale and retail trade

Post and telecommunication Finance and

insurance

Real-estate activities

Computer and related activities

R&D

Pulp, paper, printing, and publishing

Agriculture, forestry,

and fishingWood products

Rubber and plastics

Basic metals

Fabricated metals

Machinery and equipment

Motor vehicles

Pharma

Chemicals

Radio, TV, and communication

equipment

Medical instruments

Aircraft and spacecraft

Other

Other

Each of the six groups comprises sectors with similar underlying economics and industry dynamics. Depending on the development stage or income level of a country, these sector groups have different degrees of importance for the overall economy (Exhibit 2).

1. Infrastructure services

Infrastructure services comprise sectors such as utilities, telecommunications, and railroads—industries with large fixed costs for the construction of network infrastructures. Because of the large economies of scale in these sectors, unregulated markets do not lead to an effective competitive dynamic among private-sector companies. Instead, industry regulation needs to set the rules of competition and incentives for efficient company operations. Regulation can change behavior—a classic example being electric utilities regulation that can pay companies to expand the volume they deliver or alternatively reward companies that promote higher energy efficiency among their customers.10 Or take mobile telecoms. The regulatory environment needs to find the right balance between the cost savings available from single large-scale operators (who can amortize network build-out costs at a lower cost per customer and save on other fixed operating costs) with the incentives created by competition to offer new, attractive, and affordable service packages to consumers.11

10 For more detail, see Curbing global energy demand growth: The energy productivity opportunity, McKinsey Global Institute, May 2007, as well as reports on energy productivity in the United States, the EU, and China (http://www.mckinsey.com/mgi/rp/energymarkets/).

11 In wireless telephony, McKinsey estimates show that the economic benefits to users exceed three times the sector value added in emerging Asian economies. See Kushe Bahl et al.,

20

2. Local services

This group provides services to local households and businesses, including wholesale and retail trade; hotels and restaurants; and finance and insurance. This group accounts for the largest employment among most middle- and high-income countries.12 Business turnover tends to be high and growth comes from more productive companies gaining share or replacing less productive ones. Competitive intensity is a key driver of growth in this group of sectors by providing an incentive for ongoing innovation and the adoption of better practices. In addition, competitive pressure ensures that companies pass productivity gains on to consumers as more attractive products and lower prices.13 The more appealing offerings in turn boost demand, creating a virtuous cycle of expanding domestic demand and sector growth. Government’s key role is to create the right policy environment to boost competition among private companies.

Exhibit 2

SOURCE: Global Insight; Economist; McKinsey Global Institute analysis

Total value added by sector group for select countries, 2005%, $ billion

5754483944403528

43

15913

9668

7

5

6111415

12

613

16

55118

Infrastructure

Local services

Business services

Resource-intensiveindustries

Manufacturing

R&D-intensivemanufacturing

United States

9,883

8

10

4

Japan

4,095

11

10

Germany

2,061

10

10

Czech Republic

96

16

17

3

SouthKorea

596

11

16

Russia

585

15

30

2

Brazil

628

15

24

5

China

1,992

10

31

India

610

13

32

43

Goods

Services

Low High

Per capita GDP, 2005$ PPP 4,136 8,209 11,893 18,753 20,203 30,160 30,309 42,6432,158

Income level

EXHIBIT 2

Service sectors constitute ~75 percent of the economy in developed countries and more than half in most middle-income countries

3. Business services

Business services including computer and related activities, R&D, and professional services can be either domestic or tradable and are the fastest-growing sector group globally. Competitive business services require a regulatory environment that enables effective competition among private companies, including sufficient intellectual property (IP) rights that are important in software, digital media, and similar sectors. Because business services typically require a skilled workforce, the quality of education and research funding also matters for competitiveness. The capacity of governments to influence sector competitiveness therefore includes not only setting the right regulatory environment (as in local services) but also creating a talent pool through basic and university education. Government can help ensure

Wireless unbound: The surprising economic value and untapped potential of the mobile phone, McKinsey & Company and GSM Association, December 2006.

12 The World Bank defines middle-income economies as those with per capita GNI in 2003 between $766 and $9,385, measured using the average exchange rate of the past two years.

13 For descriptions of how IT use diffused across retail and retail banking companies in the United States as a result of competitive pressure, see How IT enables productivity growth, McKinsey Global Institute, October 2002 (www.mckinsey.com/mgi).


sufficient skills by supporting local research capabilities through government contracts (e.g., defense contractors or technical consultants) or through R&D subsidies to the private sector (e.g., public innovation funds or research grants).

4. R&D-intensive manufacturing

In these fast-moving, globally traded sectors such as pharmaceuticals or radio, television, and communication equipment, the capacity to deliver differentiated products swiftly to market is critical. Global industry dynamics and competition between companies determine the growth of local industries. Success requires a skilled workforce that can continuously deliver competitive products for new generations of technology, keeping pace with a changing marketplace. Low-cost production capacity is also important if companies are to compete on price, as is the case with more established products.14 Intense global competition explains the rapid productivity growth in these sectors and ensures that benefits from innovation pass on to consumers in the form of lower prices.15

The rapidly changing nature of industries in this group has made it hard for governments to influence competitiveness and performance directly. Government efforts to set the direction of technological development, for instance, have largely failed.16 It is true that public policy makers can strengthen the attractiveness of their location by acting as an enabler—for example, training a skilled workforce, a necessary condition for any R&D-intensive activity; supporting R&D activities through universities or other research funds; and creating domestic demand for emerging new solutions (e.g., feed-in tariffs for wind or solar power). Some governments have played a useful enabling role but, in general, the odds of successful public interventions in these sectors are low and often expensive. Indeed, collectively government support across countries can lead to global overcapacity and low returns to investors, as we have observed in the semiconductor industry.

5. Manufacturing

Manufacturing sectors such as motor vehicles, cloth and apparel, and food, drink, and tobacco are tradable and compete on both cost and the capacity to differentiate on quality and brand. Competitiveness depends on a broad set of factors that together determine the “value for money” delivered. Because the importance of different factors varies according to the specific activity, countries’ competitiveness needs to be assessed for specific products and/or steps in the value chain. For instance, the roles of technical expertise, logistics, and labor costs vary between different automotive or computer components.

14 In many segments, product-related services can be a very important part of a differentiated offering. Services represent more than 50 percent of revenues for computer companies IBM and HP as well as elevator supplier Otis and Rolls-Royce’s engine division. These service sectors range from customized software services to elevator and airplane engine maintenance contracts.

15 The example of semiconductor and computing products illustrates how lower prices for better products has helped grow the market by expanding the user base. However, these lower prices also mean that investment in productivity improvements in these sectors may not be captured by companies in the sector itself (e.g., despite the semiconductor sector being a major contributor to US productivity growth over the past 15 years, its share of GDP and employment has actually declined).

16 Examples include France’s Minitel program, a publicly supported precursor to the Internet, and Brazil’s unique TV standards. For more detail on the latter, see New horizons: Multinational company investment in developing economies, chapter on consumer electronics, McKinsey Global Institute, October 2003 (http://www.mckinsey.com/mgi/reports/pdfs/newhorizons/Consumer.pdf); also see E. Luzio and S. Greenstein, “Measuring the performance of a protected infant industry: The case of Brazilian microcomputers,” Review of Economics and Statistics, 77, 622–33, 1995.

22

Because they see manufacturing as an important source of attractive jobs and export revenues, governments frequently use policy to foster emerging local production or to support ongoing operations. The policy tools used have varied widely, ranging from protecting local production from global competition (typically through trade barriers or local market regulations) to providing incentives for exports (through favorable financing to local companies or incentives to foreign investors) or providing financial backing for ailing local players. In some sectors like automotive, policy has not only shaped global trade and production patterns but also contributed to expanding the world’s capacity through investment incentives, changing the global industry economics. Our research shows that there is no one-size-fits-all policy—a wide variety of approaches have helped establish a local manufacturing industry in different regions. A government’s capacity to boost growth depends on whether it targets policy at activities with real potential for comparative advantage, as well as how it executes those policies.

6. Resource-intensive industries

Resource-intensive industries such as oil, coal, and basic metals, as well as agriculture and forestry, are typically tradable-commodity businesses that require substantial up-front capital investment. Cost is the major purchase factor, and measuring sector competitiveness in these sectors relies on understanding the cost position relative to other suppliers.17 Cost-competitive regions usually have access to natural resources, sufficient scale and operational efficiency, and logistical network to access major markets.18 Yet the large costs and the time it takes to adjust capacity make these sectors susceptible to large swings in price and capacity utilization when demand trends change.

Government role in these sectors is typically much broader than solely establishing an efficient market environment. First, policy needs to decide who has access to natural resources and under what terms, determining industry incentives and the capacity for growth and efficiency.19 Second, many of these industries go through an inverted-U development cycle. Governments help shape the evolution of the industry structure, which, because of large fixed costs, typically adjusts more slowly than is the case in services. Early in a sector’s development, governments have helped fund new capacity either directly through state-owned enterprises or by providing trade protection or favorable financing to private investors. In the mature phase, governments tend to focus on coordinating downsizing and restructuring to reduce overcapacity.

17 For a description of McKinsey’s cost-based supply-curve methodology for understanding the competitiveness of different suppliers, see Carter F. Bales et al., “The microeconomics of industry supply,” McKinsey Quarterly, June 2000.

18 The relative importance of these factors varies by industry. For extractive industries such as oil or natural gas, access to the resource is critical. For more processed basic metals like steel and aluminum, scale, technology, and operational efficiency are also very important. The role of logistics depends on the value-to-bulk ratio of products and whether industries (such as oil and natural gas) compete globally or are more narrowly bound to a particular region (as in coal or flat steel).

19 See Unlocking economic growth in Russia: Oil sector, McKinsey Global Institute, October 1999 (www.mckinsey.com/mgi); and Productivity-led growth for Korea: Steel sector, McKinsey Global Institute, March 1998 (www.mckinsey.com/mgi).


23

A granular analysis of competitiveness in each sector, rather than simply looking at the aggregate, macroeconomic level, reveals important insights. Our research has found three key patterns that we believe should inform efforts to promote competitiveness:

1. The competitiveness of sectors matters more than the sector mix. Some governments worry about the “mix” of their economies, but our research finds that countries outperforming their peers do not have a more favorable sector mix propelling higher growth. Rather, their individual sectors are more competitive than their counterparts elsewhere.

2. To generate jobs, service-sector competitiveness is the key. In economies as a whole, increasing productivity is essential to overall GDP growth. But patterns of growth differ between sectors. A sector’s growth—defined as its contribution to aggregate GDP growth—can come from expanding employment or boosting productivity. Productivity improvements are a key factor in all sectors, but services have accounted for all net job growth in developed economies and 85 percent of net new jobs in middle-income countries.

3. Competitiveness in new innovative sectors is not enough to boost economy-wide employment and growth. Although innovations in niche sectors can enable business process improvements in other sectors, growth in “cutting-edge” emerging sectors such as cleantech alone will not boost economy-wide competitiveness. Such sectors are too small.

As a starting point to any effort to boost growth and competitiveness, governments need to take account of the stage of development of their economy, which matters for the role different sectors play in overall GDP growth. Expertise honed during the industrial stage of development is likely to prove inappropriate when an economy has entered its mature phase and the challenge is to boost the competitiveness of service sectors.

The evolution of sector contributions to value added as economies develop is one of the most consistent economic patterns observed. Essentially, the share of agriculture tends to decline in the early stages of economic development. Then, in the middle-income stage, an inverted-U shape is typical as industrial sectors peak and then begin to decline. Services grow continuously as a share of GDP as we move along the income and economic development curve (Exhibit 3).20

20 Many early development economists have recognized this pattern, including A. G. B. Fisher in The Clash of Progress and Security, London: MacMillan, 1935; C. Clark, The Conditions of Economic Progress, London: MacMillan, 1940, revised and reprinted in 1951; Simon Kuznets, Modern Economic Growth: Rate, Structure and Spread, New Haven and London: Yale University Press, 1966; P. Kongsamut, S. Rebelo, and D. Xie, “Beyond balanced growth,” Review of Economic Studies, 2001, 68, 869–82; and V. R. Fuchs, The Service Economy, New York and London: Columbia University Press, 1968.

2. Patterns in sector contributions to growth challenge conventional wisdom

24

Exhibit 3Advancing through the developmental stages, the relative importance of sectors shifts

Low-income countries

0

10

20

30

40

50

60

70

80

1970 1980 1990 2000

Middle-income countries High-income countries

EXHIBIT 3

% of GDP, 1970–2001

1 Industry: manufacturing, mining, and construction; services: personal, professional, and public-sector services and utilities. 2The World Bank defines middle-income economies as those with per capita GNI in 2003 between $766 and $9,385 measured

with average exchange rate over past two years.

SOURCE: World Development Indicators, World Bank; McKinsey Global Institute analysis

Services1

Industry2

Agriculture

0

10

20

30

40

50

60

70

80

1970 1980 1990 20000

10

20

30

40

50

60

70

80

1970 1980 1990 2000

Because of these patterns, the stage of development of an economy matters to the role different sectors play in overall GDP growth. In low- and middle-income economies, the performance of expanding industrial sectors is critical. We are not aware of any emerging economy that would have sustained rapid growth without a substantial contribution from its industrial sector.21 While there is growing interest in finding more carbon-light growth paths for emerging economies to “leapfrog” over their industrial phase, the past doesn’t provide us with any models to follow. Among middle-income economies, industry has contributed a little less than half of all growth (46 percent) while the contribution of services has been just over half (54 percent). On average, this broadly reflects the share of these two sectors in the economy (Exhibit 4).

In high-income economies, services represent about three-quarters of value added and have contributed 87 percent of GDP growth since 1985, a trend we expect to continue (Exhibit 5). At this stage of development, the biggest challenge is how to downsize mature, increasingly labor-light industrial capacity, and to replace lost jobs in high-skilled and service-sector activities. In the latter case, well-functioning domestic markets become an increasingly important factor determining the overall performance of an economy.22 As these economies move through this cycle of creative destruction, policy makers need to learn new skill sets. Expertise learned in direct industrial support

21 Also see Dani Rodrik, “Industrial development: Some stylized facts and policy directions,” in Industrial Development for the 21st Century: Sustainable Development Perspectives, Department of Economic and Social Affairs, United Nations, 2007 (http://www.un.org/esa/sustdev/publications/industrial_development/full_report.pdf); and John Weiss, Export Growth and Industrial Policy: Lessons from the East Asian Miracle Experience, ADB Institute Discussion Paper No. 26, February 2005 (http://www.adbi.org/files/2005.02.dp26.eastasia.govt.policy.pdf).

22 South Korea and the Republic of Ireland are both examples of countries that have been phenomenally successful in their goods-producing sectors, but at a cost to the competitiveness of local services. This will be the next frontier for both. For more details on the Republic of Ireland, see Diana Farrell, Jaana Remes, and Conor Kehoe, “Service sector productivity: The tiger’s next challenge,” chapter 2 of Perspectives on Irish Productivity, Forfas, March 2007 (http://www.forfas.ie/media/productivity_chapter2.pdf ). Also see Productivity-led growth for Korea, McKinsey Global Institute, March 1998 (www.mckinsey.com/mgi).


is inappropriate for service sectors where governments can be most effective when playing a more indirect role in enabling private-sector-driven growth.

Exhibit 4

32

7

15

7

15

46

24

100

54

SOURCE: Global Insight; International Labor Organization; National Statistics; McKinsey Global Institute analysis

1 World Bank defines middle-income countries as countries with 2008 per capita GNI from $976 to $11,905. Value-added and employment data available in Argentina, Bolivia, Brazil, Bulgaria, China, Colombia, Costa Rica, Egypt, Hungary, Jordan, Malaysia, Peru, Philippines, Poland, Romania, Slovakia, Sri Lanka, Thailand, Turkey, and Uruguay.

Sector contribution to growth of value added and employment in middle-income countries1, 1985–2005100% = $2.6 trillion

EXHIBIT 4

In middle-income countries, services have contributed just over half of overall growth, and goods-producing sectors the rest

Goods

Services


Manufacturing


Business services

Local services

Infrastructure

Exhibit 5

58

18

4

12

13

100

2

87

6


1 World Bank defines high-income countries as those with 2008 per capita GNI of $11,906 or more. Value-added and employment data available in EU-15, Australia, Canada, Hong Kong, Japan, South Korea, New Zealand, Norway, Singapore, Switzerland, and the United States.

Sector contribution to growth of value added and employment in high-income countries1, 1985–2005100% = $10.4 trillion

EXHIBIT 5

Services have contributed 87 percent of GDP growth in high-income countries in the last decades

Goods

Services

R&D-intensive manufacturingManufacturingResource-intensive industries

Business services

Local services

Infrastructure

In the next three sections, we discuss the three major patterns that emerge from our analysis.

26

2.1 The competitiveness of sectors matters more than the sector mix

Some observers argue that countries can outperform their peers because they have a mix of sectors that has a more favorable growth momentum. Our analysis clearly indicates that this is not the case. In fact, the mix of sectors does not explain differences in the growth performance of countries with similar income levels at all.23 The mix of sectors is surprisingly similar across countries at broadly equivalent stages of economic development. Most countries—and large regions—have a large share of comparable activities including retail and other local services, local manufacturing like food processing, as well as construction, transportation, and other infrastructure services. The small deviations in these sector shares matter less than their performance relative to their peers.24

Over the past decade, overall GDP growth in developed countries has ranged from 0.4 percent annually in Japan to 3.3 percent in the United States (see the left column of Exhibit 6). Taking into account that every country has its own mix of sectors—within a broadly similar pattern—we calculated how much each country would have increased its value added if each sector had grown at the average rate in these countries. This growth—predicted by a country’s specific sector mix or “growth momentum”—actually shows a very narrow distribution of between 1.8 percent for South Korea and 2.3 percent for the United States, France, and Germany (see the middle column of the exhibit). By contrast, the difference between the real growth rate and this growth momentum is much larger, ranging from 0.9 percent in the United States to minus 1.7 percent for Japan (see the column to the right).

This illustrates that it is not the mix of sectors that decides the growth in developed economies but rather the actual performance within the sectors compared with their counterparts in peer economies.25

This exercise produced a similar pattern in developing countries (Exhibit 7). There was a slightly wider variation in terms of the growth predicted by a country’s specific sector mix—the growth momentum—from 5.2 percent for India to 6.7 percent in Russia. This is largely as a result of differences in shares of agriculture and manufacturing in the early stages of economic development. Nevertheless, the exhibit again demonstrates that it is the variation in the actual performance of the countries highlighted within their given sector mix—from 3.4 percent in the case of China to minus 4.1 percent for South Africa—that explains overall differences

23 In the very early stages of economic development, the shift of labor from agriculture to more productive industries and services is a major contributor to growth. We focus on economies where this sector transition has largely occurred. Our findings are consistent with Bart van Ark, “Sectoral growth accounting and structural change in post-war Europe”, in B. Van Ark and N. F. R. Crafts, eds., Quantitative Aspects of Post-War European Economic Growth, pp. 84–164, Cambridge, MA: CEPR/Cambridge University Press; and Florence Jaumotte and Nikola Spatafora, “Asia rising: Patterns of economic development and growth,” chapter 3, World Economic Outlook, International Monetary Fund, September 2006. Also see Diana Farrell, Antonio Puron, and Jaana Remes, “Beyond cheap labor: Lessons for developing economies,” McKinsey Quarterly, 2005 Number 1 (www.mckinseyquarterly.com).

24 Furthermore, the current size of a sector may not be a good predictor of a sector’s capacity to grow in the future. Germany and South Korea have a larger share of manufacturing in their economies than the United States or Singapore—yet the contribution of the manufacturing sector to overall growth will depend on the capacity of these countries to outperform their peers.

25 Our sector categories included more than 100 sectors found in McKinsey’s sector-growth database. The results hold if we limit the sectors to two-digit International Standard Industrial Classification (ISIC) categories.


in growth. China displayed the lowest growth momentum but the highest actual growth. South Africa had the highest growth momentum but the lowest overall growth. This demonstrates the fact that, even if they started with a less favorable sector mix, the fastest-growing countries outperformed their peers in terms of their sector competitiveness.26

Exhibit 6

2.1

2.3

2.3

2.2

1.8

2.3

Sector performance has mattered more than the mix of sectors foroverall GDP growth in developed countries

SOURCE: Global Insight; McKinsey Global Institute analysis

Growth Total growth

0.4

0.8

2.1

2.6

2.6

3.3

Growth momentum (growth predicted by initial sector mix)1

Differences in performance of sectors2

-1.7

-1.5

-0.2

0.4

0.7

0.9

Contribution to total value added, 1995–2005Compound annual growth rate, %

1 Country growth rate calculated as if all sectors would have grown with sector-specific growth rate average across all developed countries.

2 Actual country growth minus growth momentum of initial sector mix.

EXHIBIT 6

United States

South Korea

United Kingdom

France

Germany

Japan

High

Low

Exhibit 7

6.0

5.9

6.7

6.0

5.2

5.7

Sector performance matters more than sector mix in developing countries as well.

SOURCE: Global Insight; McKinsey Global Institute analysis

Growth Total growth

1.9

3.5

3.6

3.9

5.5

9.1

Growth momentum (growth predicted by initial sector mix)1

Differences in performance of sectors2

-4.1

-2.5

-3.1

-2.1

0.3

3.4

Contribution to total value added, 1995–2005Compound annual growth rate, %

High

Low

1 Country growth rate calculated as if all sectors would have grown with the sector-specific growth rate average across all developing countries.

2 Actual country growth minus growth momentum of initial sector mix.

EXHIBIT 7

China

India

Mexico

Russia

Brazil

South Africa

26 There are many reasons that explain the differences in sector performance across countries, including the general macroeconomic and policy environment, sector-specific regulation, and various starting points. Understanding the role of these different factors is the key focus of this research project.

28

2.2 To generate jobs, service-sector competitiveness is the key

Not all growth is created equal. In other words, the drivers of growth differ from sector to sector. As we have noted, sector growth can come either from expanding sector employment or by increasing productivity. Policy makers seeking to expand employment opportunities need to differentiate between those sectors where growth is largely a productivity story with a flat or declining employment trend and sectors where new job generation largely fuels growth—focusing their efforts on the latter.

As we have noted, growth patterns vary by level of income. In developed economies, almost 90 percent of value-added growth comes from services and only 10 percent from goods-producing industries. And in goods-producing sectors, growth has come from productivity growth as overall employment has declined. Productivity gains in these sectors have contributed 0.6 percent a year to economy-wide productivity growth in developed economies, while declining employment shaved 0.3 percent annually off total employment in these economies between 1995 and 2005. At best, a handful of successful countries—including Finland—have been able to replace lost manufacturing jobs with new ones, thereby keeping overall manufacturing employment stable.

The large contribution of services to overall GDP growth in developed economies is due to both net employment and productivity growth. Service sectors have been the source of all net job creation in developed economies. Differences in domestic service-sector job creation explain most of the overall variation in job generation among developed economies. In addition, productivity growth across all kinds of services, including local services where process innovations can be important, has been a major contributor to overall sector growth (Exhibit 8).

Exhibit 8


Growth of value added

Growth of labor productivity

Growth of employment

2.6

0.3

Total

Services 2.2

Goods 1.4

0.6

0.8

1.1

1.5

-0.3

EXHIBIT 8

Sector contribution to growth of value added, labor productivity, and employment for high-income countries1Contribution to compound annual growth rate 1985–2005

In high-income countries, services generated more than 100 percent of net job growth, and productivity grew across the board

1 World Bank defines high-income countries as those with 2008 per capita GNI of $11,906 or more. Value-added and employment data available in EU-15, Australia, Canada, Hong Kong, Japan, South Korea, New Zealand, Norway, Singapore, Switzerland, and the United States.


In middle-income countries, the story is more mixed as both goods-producing sectors and services have expanded employment and boosted productivity. Productivity improvements deliver more than 70 percent of value-added growth. Goods contribute almost 60 percent of overall productivity growth, and services contribute the rest. However, service sectors are responsible for 85 percent of all net growth in employment in these countries (Exhibit 9).

Exhibit 9


Growth of value added

Growth of labor productivity

Growth of employment

5.0

2.3

Total

Services 2.7

Goods 3.6

2.1

1.5

1.4

0.2

1.2

EXHIBIT 9

Sector contribution to growth of value added, labor productivity, and employment for middle-income countries1Contribution to compound annual growth rate 1985–2005

In middle-income countries, productivity and job growth across a broad range of sectors explains overall GDP growth

1 World Bank defines middle-income countries as those with 2008 per capita GNI from $976 to $11,905. Value-added and employment data available in Argentina, Bolivia, Brazil, Bulgaria, China, Colombia, Costa Rica, Egypt, Hungary, Jordan, Malaysia, Peru, Philippines, Poland, Romania, Slovakia, Sri Lanka, Thailand, Turkey, and Uruguay.

2.3 Competitiveness in new innovative sectors is not enough to boost economy-wide employment and growth

Engaged in the art of the possible, many governments are tempted to focus on emerging, innovative sectors as the key to their economies’ future competitiveness. Green or cleantech is all the rage with governments around the world as they seek ways to promote renewable energy technologies including solar and wind power and biomass. This aspiration is consistent with the past when governments saw the development of high-tech clusters including semiconductors as the route to economy-wide competitiveness.

It is true that cutting-edge new growth sectors—often in the vanguard of technological change—can make a critical difference to a smaller region or a city (e.g., the town of Oulu in Finland, home to a mobile-communications cluster). However, governments looking to these sectors as new sources of economic activity and jobs will largely find themselves disappointed. Boosting the competitiveness of such sectors alone is not sufficient to sustain economy-wide growth in large, diversified economies, simply as a matter of arithmetic (Exhibit 10).

Even if emerging innovative sectors offer high levels of value added per worker and grow quickly, they are simply not big enough to make a significant difference to a large economy’s overall growth rate, even taking into account potential linkages through

30

their suppliers. For instance, the phenomenally successful US semiconductor industry currently generates only around 0.4 percent of US value added, down from 0.6 percent in the boom year of 2000. India’s software sector is one of the most dynamic industries in one of the fastest-growing economies in the world—yet it only accounts for 0.7 percent of GDP (including both the broad IT-services sector and packaged software) and 0.1 percent of overall employment. Compare this with Indian manufacturing industries that collectively contribute 16 percent of GDP and employ 11 percent of the country’s workforce.

Exhibit 10Even in the United States, innovative new sectors make a very small economic contribution compared with large, established sectors

SOURCE: The Clean Energy Economy, PEW, 2009; Bureau of Labor Statistics; Haver analytics

Share of US employment, August 2009Percent of nonfarm employment100% = 130 million

New innovative sectors

0.60.30.2

Biotech CleantechSemiconductor

11.3

5.94.9

Construction Retail tradeFinancial activities

Existing large employment sectors

EXHIBIT 10

While emerging sectors are small, their innovations can have much larger spillover effects in the broader economy if they enable business-process improvements in other sectors. For example, the semiconductor and software industries have helped to increase labor productivity in securities trading substantially by facilitating the move to online trading systems. Increasingly sophisticated retail supply-chain management software has contributed not only to lower logistical costs but also to more accurate product stocking and selection. Yet these user benefits are not guaranteed; most productivity benefits require organizational and business-process changes that require much more than enabling technology solutions.27 Nor do these user benefits typically require local suppliers, as imported software solutions or computers can generate similar outcomes. So, even taking into account the spillover benefits generated by innovative sectors, the fact remains that these sectors alone cannot fuel economy-wide growth.

Governments therefore need to pursue policy efforts across the broad swathe of existing industrial and service sectors. This stands to reason. The large employment base of many of these activities means that even small differences in productivity growth can make a big difference for overall GDP growth—much bigger than even double-digit growth in a small niche segment. Take US retail as an illustration. To produce the same overall GDP growth as a 1 percent increase in the productivity of the substantial retail sector, the United States would have to increase productivity in its successful, but smaller, semiconductor sector by almost 15 percent.

27 See How IT enables productivity growth, McKinsey Global Institute, October 2002 (www.mckinsey.com/mgi).


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3. Governments need to tailor policy to each sector

To boost the odds of success, governments need to tailor policies and the range of available policy tools to suit each sector and then implement policy in close collaboration with the private sector. The spectrum of available public-policy intervention ranges from a hands-off approach limited to creating the necessary market institutions to being a central operator in a sector.

We analyzed the policies used in different sectors in four categories that demonstrate an increasing intensity of intervention:

1. Setting the ground rules and direction. Governments can limit sector policies to setting the regulation covering labor and capital markets as well as the general business environment, and setting broad national priorities and road maps.

2. Building enablers. Without interfering with market mechanisms, governments can support private-sector activities by expanding hard and soft infrastructure, helping to ensure adequate skills through education and training, and supporting R&D.

3. Tilting the playing field. Governments can choose to create favorable conditions for local production, typically through trade protection from global competition, the provision of financial incentives for local operations, or by shaping local demand growth through public purchasing or regulation.

4. Playing the role of principal actor. At the interventionist end of the policy spectrum, governments may play a direct role by establishing state-owned or subsidized companies, funding existing businesses to ensure their survival, and imposing restructuring on certain industries.

The nature of the sector matters for the kinds of policies that are effective in promoting competitiveness. Exhibit 11 demonstrates what experience teaches us are likely to be the most impactful policy approaches for each of the six sector groupings in our framework.28

In nontradable sectors, sector performance correlates closely with the local policy environment that sets the “rules of the game” for competitive market dynamics. MGI case studies of the telecommunications and retail sectors show that the employment and productivity outcomes of countries reflect the incentives to companies set by the regulatory environment—and that policy changes can impact sector performance in two to three years.

In traded sectors, where success requires local companies to be competitive in the global marketplace, it is harder for government policy to impact performance as directly and there is less room for error. Some regulations can unexpectedly halt

28 We synthesize our findings from more detailed case-study findings into patterns for the six broad sector groupings we use as a framework for action in the chart. Governments should also be more granular in their approach, tailoring policies for each sector, subsector, and step in the value chain.

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sector growth—as obscure national security review requirements did for Russian software exports. In addition, financial incentives to failed initiatives can costs governments billions, as many semiconductor ventures have done around the globe. The best odds for sustained growth come with efforts to enhance competitiveness that target those activities with a realistic potential for competitive advantage.

Beyond sector-specific policies, government can plan a positive coordinating role across private-sector activities in a sector such as tourism (see box 3, “The importance of government as coordinator in tourism”).

Exhibit 11Government policy tools need to be tailored to suit sector competitiveness drivers

SOURCE: McKinsey Global Institute/Public Sector Office Sector Competitiveness Project

Government as principal actor

Tilting the playing fieldBuilding enablers

Setting ground rules/direction

EXHIBIT 11

Infrastructure

Degree of intervention


Infrastructure

R&D-intensive manufacturingBusiness services

Local services Manufacturing

HighLow

Box 3. The importance of government as coordinator in tourism

Many governments have been proactive in their efforts to boost the growth of tourism in their regions.29 Becoming an attractive location for tourists requires a wide range of services, from the construction of large-scale airport and road infrastructure to the provision of fragmented hotel and restaurant services. Experience shows that government efforts to orchestrate consistency between visitor expectations and this range of services have been important for success.

Competitive tourism regions need to satisfy some basic necessary conditions that depend directly on the government. These conditions include adequate transportation infrastructure, as well as safety, security, and sanitation. Often a thriving tourism sector needs government to create the right zoning and partnership models to deliver other services, including hotel zones and “flagship”

29 Tourism is an attractive sector for many governments because it is both labor intensive (unlike the other sectors we studied, overall sector growth is driven by employment rather than productivity growth) and has large local linkages and spillover effects. In the case of linkages, we refer to backward multiplier effects when workers in the tourism sector spend their wages on local stores, restaurants, and so on. By spillover effects, we mean economic benefits beyond those direct linkages, including the lower cost of transportation for other sectors when airports and roads are improved and the benefits to local consumers from the “beautification” of the environment.


tourist attractions. Government also has a role to play in ensuring a consistent brand and the effective communication of tourism opportunities.

The experience of growing tourism industries in different countries demonstrates the importance of these government roles. For instance, Mexico’s development of the upmarket Riviera Maya beach resort area relied on broad, cross-sector, coordinated public-sector efforts based on a good understanding of target tourism segments. The government used zoning to ensure the development of exclusive hotels, upscale restaurants, and boutiques that enabled average hotel rates double those of Cancun, a more tightly built beach resort with a deteriorating image 65 kilometers to the north. In Morocco, the highest level of government (including the king) committed to developing the country as a tourism destination. Government acted as coordinator, designing the strategy and setting up an agency to manage the project, fund marketing, monitor progress, and collaborate closely with the private sector. Together with tax exemptions in favor of the industry, this high degree of coordination from the center has almost doubled international arrivals in six years. In both cases, government acted as a “strategic

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